Financial Meltdown 101: 10 Reasons Why Banks Fail

Our forefathers knew that a strong banking system would be critical to the growth and prosperity of our country. In recent decades, banks have expanded, acquired competitors and have taken on more risk after the repeal of Glass-Steagall in an effort to earn more profits. The resultant bank failures have been traumatic events for the economy.

1. Bad loans. Loans comprise a large part of the traditional banking business, along with holding depositor money. Before the later part of the 20th century, banks primarily made loans to individuals to buy homes and to businesses to enable them to grow. Credit analysis skills are critical to this line of business. In this regard, most large banks have huge training programs dedicated to the development of new lending officers, who are taught how to assess the risks of borrowers and protect the bank’s assets and profitability. When credit standards are lowered, to attract more lucrative business, loan losses inevitably increase and create financial problems. In the past, risky loans to foreign countries, real estate investment trusts, and mortgage companies have created severe problems for banks and ultimately caused some to fail.

2. Funding issues. Banks have balance sheets that carry huge amounts of assets. These assets are generally financed with a combination of short-term credit, bonds and equity. When a bank has problems refinancing its debt or repaying it, the bank may fail. Funding problems are sometimes related to general market conditions, but more often occur because investors lose faith in the bank for some reason.

3. Asset/liability mismatch. When a bank’s assets are unmatched to the liabilities supporting them, severe problems can arise. The simplest example is a floating rate liability financing a fixed rate loan. If interest rates rise, the bank pays greater and greater interest on its liability while the fixed rate loan pays the same rate. This mismatch can result in a huge loss. When a large portion of a bank’s portfolio is mismatched, the results can be devastating.

4. Regulatory issues. When American authorities blackball foreign banks, they may be forced out of business. This could occur because the bank is located in a rogue country or the bank could be engaged in illegal activities such as money laundering.

5. Proprietary trading. This newest and soon to be banned bank business created huge exposures for banks. For the most part, proprietary businesses generated large profits. But regulators believe the possibility of large losses more than offsets the profit potential. Basically, the business included investment in unhedged derivatives, large blocks of marketable securities, exotic instruments and illiquid investments.

7. Risk management decisions. All large banks have extensive risk management groups that constantly quantify the absolute level of risk in the bank’s portfolios. They measure risk from every conceivable perspective including interest rate risk, foreign debt risk, investment risk and much more. When miscalculations occur in conjunction with a significant market movement, huge losses are possible.

8. Inappropriate loans to bank insiders. In the 1980s, many savings and loan banks made risky loans to directors and insiders for real estate and many other projects that were ill-conceived. These transactions resulted in huge losses and many bank failures.

9. Rogue employees. Rogue traders who are unable to cover losses and bypass internal controls have brought down a number of financial institutions or set them back significantly. The JPMorgan hedging debacle may turn out to have some of these same characteristics.

10. Runs on banks. Depositors do not subject banks in the U.S. to runs because the Federal Deposit Insurance Company guarantees deposits up to a certain amount. But, in other places (like Europe), the risk still exists. If depositors all demand their money, a bank will likely fail.

Banks are temperamental and sensitive businesses because they operate with significant leverage. For this reason, in the U.S. they are highly regulated and not permitted to engage in any number of financial activities. Additionally, banks currently are being subjected to higher capital ratios to offset the new risks they have assumed over the past 30 or 40 years. The result may be an inability to earn profits equal to those earlier in the decade.

Most important is the fact that many banks are too big to fail and will receive federal support if they have serious problems. The response by regulators and Congress is the Dodd-Frank bill, the Volcker Rule and much more supervision.